Most retirement funds in South Africa provide their members with lump sum death and disability benefits, in addition to the retirement savings. These benefits can be in the form of an income or a lump sum amount. These additional benefits are normally called “risk benefits”.
Trustees normally appoint insurance companies to provide these benefits to their members, in exchange of paying a regular (usually monthly) premium. However, Trustees can also provide these benefits directly from within the fund, without utilising an insurance company.
In this article, we focus on the provision of lump sum death and disability benefits without going through an insurance company.
Concept of self-insurance
Self-insurance is a concept whereby a retirement fund, sets aside money within the fund and uses that money to pay for lump sum death and disability benefits as and when members or their families claim for the benefits. Therefore, when a fund is self-insured, instead of paying premiums to an insurer, premiums are retained within the fund. When death and disability claims arise, the fund uses the retained premiums to pay these claims.
The objective of self-insurance is to reduce the cost, to members and/or employers, of providing these benefits in the long term.
Self-insurance vs insurance through a registered insurer
The table below shows a comparison of self-insurance and insurance through a registered insurer:
Under self-insurance, any excess premiums, after paying claims, expenses, reinsurance premiums, and providing for capital requirements, are retained in the fund as profits owned by members of the fund. There will also be times when premiums are not sufficient to cover all the deductions. In this case, the trustees make use of reserves in the fund to cover the shortfall. If reserves are insufficient to cover the shortfall, then this would lead to a deficit. The deficit would most likely have to be recouped from higher future premiums.
When a fund provides risk benefits through an insurer, any excess premiums after allowing for all the necessary deductions belongs to the shareholders of that insurance company.
When a fund is self-insured, it has to be managed in a similar way to how insurance companies are managed, following the same principles of insurance that are applicable to insurance companies. The main difference between the two approaches will be in the ownership of any profits or losses as well as in the scale of the business. If a less stringent approach is used in the management of self-insured schemes, the security of risk benefits as well as retirement benefits may be compromised.
Considerations for self-insurance
Self-insurance can assist trustees of retirement funds to reduce the cost of providing risk benefits in the long term. However, not all funds can be self-insured. Therefore, it is important that any fund considering self-insurance, be subjected to a thorough investigation to assess if it has the requisite characteristics for self-insurance to be applied.
The following factors need to be considered when evaluating self-insurance for a fund:
Membership size of the fund: The larger the membership of the fund, the more stable the claims experience and the more predictable the premium. A membership of at least 10 000 is generally recommended. However, retirement funds with sizeable reserves can self-insure their risk benefits even if the membership is lower.
Availability of reserves: Reserves are required to pay for claims during periods when premiums are not sufficient to cover claims and expenses. This can happen during a pandemic or disaster, when there is an unusually high number of claims, or due to normal random fluctuation of claims. When a fund has a lot of reserves, it can afford to self-insure even when membership is low.
Risk appetite of the trustees: Self-insurance poses many risks for the members and the trustees. Therefore, trustees must have an appetite for the extra risks that self-insurance brings into the fund, in particular, the risk of insolvency, when the fund is unable to pay for all the claims coming through.
Availability of reinsurance: Reinsurance is a critical risk mitigation tool that is used in self-insurance. Therefore, before a scheme can embark on self-insurance, they need to assess the availability of the reinsurance that they need at a reasonable cost. The need for and level of required reinsurance increases when the level of reserves is low.
Salary distribution and outliers: Level of salaries determines the level of risk benefits payable. Self-insurance is more conducive for retirement funds whose membership earn more or less the same salary. Where there are outliers, whose salaries are disproportionately higher than the majority of the members (e.g. CEO is also a member), the trustees must ensure that there is sufficient reserves in the fund to pay such claims when they arise. If there is no sufficient reserves in the fund, then the trustees should consider reinsuring part of the benefit or the whole amount for such people.
Approved benefits: Retirement funds may only self-insure approved risk benefits such as lump sum death and disability benefits. Unapproved risk benefits such as funeral benefits and income disability benefits may not be self-insured.
Viability of self-insurance: Self-insurance should only be considered where there is evidence that the scheme will be profitable at current premium rates. It would not be sensible to self-insure a loss making scheme, as that will require an increase in premium from day one.
Challenges with self-insurance
If a fund does not have the initial capital required to kick start self-insurance, it will not be able to self-insure its risk benefits even if other factors support self-insurance.
When a defined contribution fund self-insurers it’s risk benefits, it’s introducing a defined benefit into a defined contribution arrangement. This exposes the fund to the risk of insolvency should claims be higher than net premiums and available reserves. A fund needs to build sufficient reserves to minimise this risk.
Some retirement funds accumulate so much reserves, way above what is reasonably required to support the self-insurance scheme. Even though this helps improve the security of benefits for members, it also means that members are not benefiting much from the self-insurance scheme as profits are not being passed onto members in the form of reduced premiums or additional bonus declarations. Once a fund has built the required level of reserves, the premiums need to be set at a level just enough to cover claims and expenses. The investment returns on the self-insurance assets can be used to reduce the premium even further down. This way, more money can be channelled towards members’ retirement savings, which is the main objective of self-insurance.
The close proximity of the claimants to the decision makers (trustees) can also pose a risk for the sustainability of self-insurance, especially where disability claims are concerned. Trustees must set out clear processes and guidelines for assessment and acceptance of claims, and exercise of trustee discretion on borderline cases must be closely monitored.
Role players required in the management of self-insurance scheme
The role players involved in the management of self-insurance schemes are as follows:
A fund interested in pursuing self-insurance should consider appointing an expert to assist with the following:
- Assessing if a retirement fund can self-insure its risk benefits.
- Setting up and managing self-insurance schemes.
- Assessing the validity of death and disability claims.
- All aspects of self-insurance requiring actuarial services, such as setting premium rates, assessing the need for and level of reinsurance required under self-insurance, determining the capital requirements and the provision for incurred but not reported claims.
Conclusion
For a fund which meets the criteria for self-insurance, self-insurance could provide a cost effective means of providing risk benefits in the long term. This will help increase the amounts allocated towards members’ retirement savings.
Investment returns on assets underpinning the self-insurance arrangement help reduce the cost of providing risk benefits even further.
